Latest / Stock Picking with Fexingo: Individual Equities, Research, and Building a Concentrated Portfolio / How to Find Moat Stocks with Growing Free Cash Flow
Transcript
- Lucas: So Apple was up nearly nine percent this past week — eight point eight to be exact. That's about twenty-six billion dollars in market cap added in five days. And the interesting thing is, this wasn't driven by a new iPhone launch or a blowout earnings report. It was driven by a slow realisation among investors that Apple's free cash flow is becoming genuinely monstrous. Luna: Monstrous how? I mean, Apple's always thrown off huge cash. What changed? Lucas: The market's starting to price in the durability of that cash flow. Apple's services revenue — the App Store, Apple Music, iCloud, Apple Pay — now accounts for about twenty-four percent of total revenue, but it's growing at double digits while hardware is flat. And services gross margins are around seventy percent, versus maybe thirty-five for hardware. So every dollar of services revenue is worth roughly two dollars of hardware revenue in terms of profit. The free cash flow yield on Apple is now about four point two percent, which is actually higher than the ten-year Treasury. And that's with the stock up eight percent this week. Luna: I have to say, a couple of dollars a month from listeners is genuinely what keeps these conversations ad-free and independent. If you've gotten something out of our episodes — whether it's a stock idea or just a better way to think about a decision — buy me a coffee dot com slash fexingo. It's the simplest way to support the show and it makes a real difference. Lucas: Yeah, absolutely. And we don't run ads, we don't have sponsors — it's just listener support. So if you can spare a few bucks, that's what keeps us going. Lucas: So back to Apple — that four point two percent free cash flow yield is remarkable because it's not just about the current cash. It's about the growth. Apple's free cash flow has compounded at about eleven percent annually over the past five years. That's faster than earnings growth, because Apple has been reducing its share count through buybacks. Less shares outstanding means each share gets a bigger piece of the cash flow pie. Luna: And that's the moat, right? It's not just that they have cash — it's that they can generate it predictably and reinvest it at high returns. But how do you find that in other stocks? Lucas: Right. The key screen is free cash flow yield above say four percent, combined with free cash flow growth that's been positive for at least three consecutive years. And you want to see that the company has pricing power — that it can raise prices without losing customers. Apple's services are sticky because once you're in the ecosystem, switching costs are high. That's the classic moat. Luna: What about a stock like Microsoft? It's up four point seven percent this week, also a services-heavy business. Does it pass the same test? Lucas: Microsoft's free cash flow yield is lower — around two point eight percent — because it's priced for higher growth. But its free cash flow has grown at about fifteen percent annually over the past five years. So you're paying a premium for faster compounding. The question is whether that growth is sustainable. Microsoft's Azure and Office 365 have recurring revenue contracts that extend three to five years. That's a strong moat, but the valuation already reflects it. Luna: So for a concentrated portfolio, you'd prefer the higher free cash flow yield with moderate growth, like Apple, over the lower yield with higher growth, like Microsoft? Or does it depend on your time horizon? Lucas: It depends on your required return. If you need a seven percent annual return over the next decade, a stock with a four percent free cash flow yield and eleven percent growth gets you there. A stock with a three percent yield and fifteen percent growth also gets you there, but you're paying more upfront and relying more on the growth materialising. In a concentrated portfolio, I'd rather have the bird in the hand — the higher current yield — because it gives you a margin of safety. Luna: And the broader market context? The S&P 500 is at 7,483, the Nasdaq at 25,833. Those are near all-time highs. Does that make free cash flow yield more or less important? Lucas: More important. When markets are expensive, you're paying a premium for future cash flows that may or may not come. Free cash flow yield is a measure of what you're getting today. The median stock in the S&P 500 has a free cash flow yield of about three and a half percent. That's below historical averages of around four point five percent. So the market is pricing in optimism. If you can find stocks with yields above four percent and growing free cash flow, you're getting a buffer against disappointment. Luna: Are there sectors where free cash flow yields are especially high right now? Lucas: Energy is one. Exxon Mobil — ticker X-O-M — has a free cash flow yield of about eight percent, but its free cash flow is tied to oil prices, which are volatile. So the high yield comes with higher risk. Financials like JPMorgan have yields around five percent, but their cash flow is driven by net interest margins, which are sensitive to the yield curve. The most attractive combination — high yield and stable growth — tends to be in consumer staples and healthcare, where companies have pricing power and recurring demand. Luna: Give me a specific example outside tech. Lucas: Take a company like PepsiCo. It has a free cash flow yield of about four point five percent. Its free cash flow has grown at around six percent annually over the past five years. That's a steady compounding machine. It's not going to double in a year, but it's unlikely to halve either. In a concentrated portfolio, that kind of stability allows you to take more risk in other positions. Luna: It sounds like free cash flow yield is a better measure of value than earnings yield, because earnings can be manipulated through depreciation or one-time items. Lucas: Exactly. Free cash flow is harder to fake. It's the cash that actually hits the bank account after all expenses and capital expenditures. Warren Buffett has said that free cash flow is what matters when valuing a business. And if you look at Berkshire Hathaway — ticker B-R-K-B — it has a free cash flow yield of about five point six percent. Berkshire's cash pile is now over three hundred billion dollars, and they're deploying it into stocks with strong free cash flow profiles. Luna: So when you're building a concentrated portfolio of ten to fifteen stocks, how many should have high free cash flow yields versus high growth? Lucas: I'd say roughly half and half. You want a core of stable cash generators — like Apple, PepsiCo, Berkshire — that provide a base return and downside protection. Then you layer in higher-growth names like Microsoft or Alphabet — ticker g o o g l — where the free cash flow yield is lower but the growth is faster. The key is that every position should have a clear moat that explains why its free cash flow will persist or grow. Luna: And how do you identify that moat? Is there a simple metric? Lucas: One good proxy is the ratio of free cash flow to sales. If a company consistently converts a high percentage of its revenue into free cash flow, that suggests it has pricing power and low capital intensity. Apple converts about twenty-four percent of its revenue into free cash flow. The average S&P 500 company converts about twelve percent. So Apple's conversion rate is twice the average, which is a strong signal of a moat. Luna: What about a company like NVIDIA — ticker N-V-D-A — which has a free cash flow yield of only about one and a half percent. Is that just too expensive, or does the growth justify it? Lucas: NVIDIA's free cash flow has grown at over forty percent annually for the past three years, driven by AI chip demand. So the low yield is a reflection of that explosive growth. But the risk is that growth decelerates — if AI spending slows, the free cash flow could stall, and the stock could drop significantly. In a concentrated portfolio, you have to decide whether you're willing to take that binary risk. I'd rather have a mix: some high-growth, high-risk positions and some steady compounders. Luna: So what's your takeaway for someone listening who wants to start screening for these stocks? Lucas: Start with a simple screen: free cash flow yield greater than four percent, free cash flow growth positive for each of the past three years, and free cash flow to sales ratio above fifteen percent. That will give you a small list of companies with durable cash generation. Then look at the business model: do they have recurring revenue, high switching costs, or network effects? Those are the moats that protect the cash flow. Finally, compare the free cash flow yield to the company's historical average — if it's above its own five-year average, you might be getting a bargain. Luna: And with the market at records, that kind of discipline seems more important than ever. Lucas: Absolutely. The S&P 500 is up about twelve percent year-to-date as of early July. Valuations are stretched. But if you can find companies that generate real cash and have the power to keep doing it, you don't need to predict the macro. You just need to own the right businesses and let the cash flow compound.